Are Financial Development and Financial Stability Complements or Substitutes in Poverty Reduction?

Abstract

This paper studies the association between financial development, financial stability, and poverty for a sample of 109 developed and developing countries from 1995 to 2018. Most of the existing studies in this literature have focused on financial development, and only a few recent studies have looked at the effects of financial stability on poverty. However, none of the existing studies has looked at the interaction effect of the two on poverty. Our contribution to this literature is manifold. First and foremost, we investigate whether financial development and financial stability are substitutes or complements in reducing poverty and find evidence in favour of the former: Financial development has greater effects on poverty alleviation in a more fragile financial system and vice-versa. Second, using two different measures of financial stability, we show that financial stability is associated with lower levels of poverty. And finally, while previous studies have presumed that the effect of financial development on poverty is homogeneous at various levels of poverty, we show that financial development and financial stability both exert heterogeneous effects on poverty depending on the level of poverty considered.

Keywords: financial development, financial stability, poverty, heterogeneous effects

JEL Classification: G20, I30, O11, O1